The Woodstock Capitalist

Below is a letter sent to the Financial Accounting Standards
Board, which was posted on its web site. It explains and debunks the standard
arguments against expensing stock options. Beneath this letter is an article
published back in 2001 that will show just how abusive stock option grants have
gotten.

March 17, 2003

The following letter explains the truth about stock options expense to anyone
who cares to understand it. If you’re ever planning on investing in any high
tech or other high growth companies, you can only ignore this issue at your
great financial peril.

An open letter to The Financial Accounting Standards Board (FASB)

The Financial Accounting Standards Board is now at a crossroads at which it
must decide whether it will be an organization that is taken seriously as a
watchdog of the accounting profession, or whether it will be the lapdog of
powerful corporate executives who deceive shareholders for their personal gain.

Senator Enzo and 14 other senators have recently taken up the crusade to
prevent FASB from requiring companies to show the cost of their executive stock
option programs. Their arguments follow the usual four thrusts, one of which has
been widely addressed in the media; the others – to my continuing amazement
– have not been addressed at all.

Here, is a list of the arguments made against expensing stock options,
followed by the refutations of those arguments.

1) Stock options are not an expense.

2) It would cost companies too much money to expense stock options.

3) The cost of stock options is already reflected in diluted earnings per
share.

4) There is no clear way to determine the exact cost of stock options.

Options not an expense: Generally Accepted Accounting Principles (GAAP)
requires that when any asset is given to an employee, or sold to an employee at
below fair market value (FMV), the difference between the purchase price
and FMV be recognized as expense to the company, and income to the employee. The
rationale is clear: If you relinquish company assets at below FMV, shareholder
value is diminished proportionately.

Although by accounting convention, a company’s own stock is considered
equity, not an asset, clearly – in real economic terms – a company’s stock
is an asset, just as it is an asset when it is carried on the balance sheet of
any other company owning it. In fact, a company’s stock has a more readily
determinable market value than any other asset it possesses. One would be hard
pressed to find on a daily basis, a generally agreed upon market price for a
used delivery truck, machine tools, or a patent. For stocks, this is easily
done.

When stock options are converted into stock and given to executives at below
FMV, shareholders have lost the amount of market value the company did not
receive for that stock. They deserve to know those figures. FASB understands
this, and has attempted to address this issue in the past. However, so far, it
has allowed this egregious exception to the logic and purpose of GAAP because of
great pressure from certain corporate interests and the politicians over whom
they wield influence.

Cost too great: This claim is a diversion. As any accountant knows, there
is no cost to reporting stock options expense. The cost is the
stock options themselves. Reporting the expense has no economic effect
whatsoever, except exposing how option grants are being abused. This exposure
will have the effect of reducing the abuse. The proponents of not recognizing
option expense go beyond "What they don’t know won’t hurt them."
They claim that it isn’t the expropriation of shareholder wealth that is
damaging to them, it is their finding out about it. The argument is absurd,
prima facie.

Cost already reflected: While it is true that the options exercised in
the current year dilute current EPS, it is grossly inaccurate to say the cost of
the stock option is fully reflected therein. A share of stock is not purchased
solely for its earnings in the current year; if it were, all stocks would sell
for less than one-times estimated forward earnings.

A share of stock represents a stake in a company’s earnings for all
future years. The true cost of an option is the present value of the discounted
cash flows of all the future earnings for which the grantee did not pay, and
undertook no risk. That cost is reflected in the difference between the market
value of the stock on the day of exercise, and the amount the grantee pays for
the stock.

No exact way to determine cost:This specious argument requires
some explanation to fully dismiss it to a layman’s satisfaction, but it is
about time someone made the effort.

The exact cost of non-qualified executive stock options (the kind we’re
discussing here) is calculated for the IRS every year when companies file their
tax returns. The compensation expense rightly recognized by the IRS is the
aggregate dollar difference between what the grantees paid for their stock, and
the FMV of that stock on the date it was issued.

I had an email exchange regarding this matter about 18 months ago with Jack
Cielieski of The Analyst's Accounting Observer. Jack has recently been
appointed to FASB’s Emerging Issues Task Force considering the stock option
issue. I have every reason to believe he is an honest and very capable
accountant. I asked Jack why the IRS method of calculating stock options expense
is not used in GAAP. He pointed out that while the IRS is willing to recognize a
tax deduction for an expense only after it has actually been incurred, financial
accounting attempts to recognize a liability for an expense as soon as it is
clear that one is likely to occur. The GAAP approach is more useful to
investors, hence, the desire to use an estimating model like Black-Scholes.

Mr. Cielieski’s point is well taken; however, the problem with the Black-Scholes
approach is that the inexact nature of it is used as an excuse by those who wish
to hide the cost of stock options expense. Their thesis is that it is better to
report no expense than inexact expense.

Of course, this bizarre logic is followed absolutely nowhere else in
financial accounting. Estimates and reserves are used more or less successfully
in many areas of accounting. No reasonable person has suggested that their
shortcomings be replaced by total lack of disclosure.

After consideration of this dilemma pitting accuracy against timeliness, my
question to Mr. Cielieski, FASB and any other party interested in this issue is
this: Why not show both the exact amount of the current expense and the
estimation of future liabilities. Specifically, why not disclose Black-Scholes
estimates of the effect on future earnings per share as a prominent footnote,
but incorporate the actual, exact cost of options exercised in the current year
in the earnings statement. In that way, the current expense will be shown and
the estimated future liability will be noted.

I know why many corporate executives will object to this method – Black-Scholes
has consistently underestimated the true expense of stock options during bull
markets – but I cannot see why those who seek accurate financial accounting
would object to this method. It treats stock options expense the same way GAAP
treats any other liability and expense.

This method, or some similar method of reserving and adjusting, would answer
all serious objections about reporting stock options expense. Of course, it does
nothing to satisfy those who are trying to obfuscate the issue for their own
personal gain.

Jack Adamo, Editor, Jack Adamo’s Insiders Plus

This is an updated rewrite of a piece I published in the summer of 2001 on
unreported stock options expense. I'm reprinting it now because legislation has
been introduced to reform this fraud, and industry groups have already begun
mounting a strong campaign to defeat the legislation.

THE GREAT ONGOING STOCK OPTION SCAM

For years there has been widespread use of stock options as an ever-growing
part of executive compensation packages. In and of itself, there is nothing
wrong with giving stock options to executives. However, the system is being
greatly abused. The abuse lies in the fact that companies are not required to
report the cost of these options in their public earnings statements. The effect
is very substantial. A recent study by The Analyst's Accounting Observer
showed that, on average, companies in the S&P 500 overstated their year 2000
earnings by an average of 9%, and

some
sectors, such as information technology companies, (read: Cisco, Dell,
Microsoft, Seibel, etc.) overstated their earnings by an average of 33%.

For years, large corporations have put pressure on The Financial Accounting
Standards Board to not require them to show this expense. FASB has continued to
be cowed and has only required companies to report the expense in the footnotes
to their financial statements, allowing the earnings in the income statement to
remain false. Now, due to rampant abuse, FASB is reconsidering, but they're
being hit with enormous pressure to back off. There has been a bill introduced
in the U.S. Senate to require companies to properly report their options
expense, but many industry groups are already waging a high pressure lobbying
campaign to defeat the bill.

When companies pay an employee in cash, cars, perquisites, land, etc. they
are required to estimate that expense in their earnings reports. If they pay
them by giving them large chunks of the company in stock options (up to 11% of
the company in some cases) it doesn't have to be shown to the public.

Dell Computer, An Egregious Example

The party line you'll hear from companies defending their stock options
programs is that the value of the options only goes up if the stock goes up, and
so, "Everyone's a winner."

The
problem with that answer is that the stock is going up based on false earnings
statements.If
the cost of the options programs were shown, the stocks wouldn't be going up
because investors would see how little these companies are really earning. When
they're earning at all.

Following is a table that shows by how much Dell Computer's Earnings Per
Share (EPS) have been overstated in the last 3 fiscal years because of FASB's
failure to require them to show options expense.

Dell Earnings Adjusted
for Options Expense

using effect of past options grants

Year

2001

2000

1999

Reported diluted EPS

.79

.61

.53

Tax-adjusted options effect per share

(.79)

(.81)

(.38)

EPS adjusted for exercised options cost

.00

(.20)

.15

As the table shows, in the last 3 fiscal years, Dell Computer actually had a
net loss, as opposed to the big earnings increases they claimed. These
calculations are based on the actual income tax deductions Dell took for
compensation expense. Though the expense was reported to the IRS, it was never
reported to the shareholders. Under current law, this is legal.

If real earnings were shown, Dell, and stocks like it, would be a lot cheaper.
What price would you pay for a stock that has a total of 5¢ per share loss in
the last three years combined? That's why tech company Insiders have been
dumping their stock for years. Even after his September public-relations ploy of
buying $75 million worth of stock, Michael Dell was still a net seller of $180
million of stock in the prior year.

I am not singling out Dell as the worst abuser of options compensation. I
don't know who would get that honor, but the report from The Analyst's
Accounting Observer lists Seibel Systems and Compaq as having overstated
their earnings last year by over 100%. That's using an estimating tool, however.
The real cost is probably much more, based on my comparison of the estimating
model and the actual calculations made after options are exercised.

Currently there's a bill sponsored in the senate by Senators Levin and
McCain. All shareholders should strongly support that bill and contact their
representatives about it. If you don't speak to or write to your
representatives, they'll listen to the money and influence of the special
interest lobbyists.

You can find your local representatives at:

http://clerkweb.house.gov/107/olm107.php3

http://www.senate.gov/contacting/index_by_state.cfm

Below is a letter you can send to your representatives. Make your voice
heard. You can cut and paste it into an email, address it to your
representative, and sign it, so that it comes directly from you.

Please don't let this opportunity to make companies report their true
earnings slip by. Invest the 5 minutes it will take you to send the note below.
It will help your investment results in the future, since you'll be able to know
the true earnings of companies in which you invest.

ALSO, PLEASE FORWARD THIS LETTER TO EVERY SINGLE STOCK OWNER YOU KNOW. AND
ASK THEM TO DO THE SAME.

Here's the letter you should email over your name. Don't forget to address
your representative by name too.

Dear Senator (or Congressman)

Senators Levin and McCain have recently introduced legislation requiring
companies to properly report the true cost of their executive stock option
programs. For years, The Financial Accounting Standards Board has allowed
companies to hide from its shareholders the stock options expense they are
reporting to the IRS. Myself and many other investors are fully aware of the
extent of their deception.

Various industry lobbying groups are mounting a campaign against this new
bill, mouthing the same old excuses they've been foisting for years. If you
believe that business is important to the health of America, you will vote IN
FAVOR of the Levin- McCain bill. Remember, THE SHAREHOLDERS OWN THESE
BUSINESSES, not the executives running the companies. It is time to force the
hired managers to STOP LYING TO THE OWNERS and report the true expenses and
profits of the companies they were entrusted to run. They must no longer be
allowed to run these businesses as their own private cash cows.

I, along with the rest of America will be watching you and your colleagues,
to see where you'll stand on this important issue.